Chapter 3 Homework

Question 1

Housing Ratio 1 (HR1)

Answer 1

This ratio reflects the proportion of gross pay on an annual or monthly basis that is devoted to housing (principal, interest, taxes, and insurance). It does not include utilities, lawn car, maintenance, etc. The benchmark for housing ratio 1 is less than or equal to 28 percent.

Question 2

Housing Ratio 2 (HR2)

Answer 2

This ratio combines basic housing costs (principal, interest, taxes, and insurance) with all other monthly debt payments, including automobile loans, student loans, bank loans, revolving consumer loans, credit card payments, and any other debt payments made on a recurring basis. The benchmark for housing ratio 2 should be less than or equal to 36 percent of gross pay on a monthly or annual basis.

Question 3

Investment Asset to Gross Pay Ratio

Answer 3

This ratio assesses a retirement plan that persistently has clients save 10-13 percent of gross pay for retirement

Question 4

Life Cycle Approach

Answer 4

This approach provides the planner with a brief overview of the client’s financial profile which permits the planner to have a relatively focused conversation with the client. it is used very early in the engagement.

Question 5

Liquidity Ratios

Answer 5

These ratio measure the ability to meet short-term obligations.

Question 6

Metrics Approach

Answer 6

This approach uses qualitative benchmarks for a measurement of where a client(s) financial profile should be. When combined with the two-step/three-panel approach, metrics help establish objectives that are measurable compared to ratio analysis.

Question 7

Net Worth to Total Assets Ratio

Answer 7

This ratio provides the planner with the percentage of total assets owned or paid for by the client.

Question 8

Non-discretionary Cash Flows

Answer 8

Mostly fixed expenses which are required to be met monthly or annually regardless of loss of income.

Question 9

Performance Ratios

Answer 9

These ratios determine the adequacy of returns on investments, given the risks taken.

Question 10

Pie Chart Approach

Answer 10

This approach is a visual presentation of how the client spends money. It provides a broad perspective on the client’s financial status and it is generally used after the collection of internal data and the preparation of financial statements.

Question 11

Present Value of Goals Approach

Answer 11

This approach considers each short-term, intermediate-term, and long-term goal, determines their respective present value, then sums all of these together and treats the sum as an obligation (liability) that is then reduced by current resources of investment assets and cash and cash equivalents.

Question 12

Ratios for Financial Security Goals

Answer 12

These ratios asses the progress that the client is making towards achieving long term financial security goals.

Question 13

Return on Assets (ROA) Ratio

Answer 13

This ratio calculates the return on investment assets.

Question 14

Return on Investments (ROI) Ratio

Answer 14

This ratio calculated the rate of return on investment assets.

Question 15

Risk management

Answer 15

Recommendations usually are related to the insurance portfolio because perils (the cause of a loss) are event driven (e.g., untimely death) or unpredictable, and can occur at any time.

Question 16

Savings and Investing Management

Answer 16

Management that results in recommendations that require both an increase in savings and an increase in the emergency fund. The savings rate (savings and reinvestment of dividends, interest, and capital gains, plus an employer match/gross pay) should equal 10-13 percent if the client only has one goal, that being financial security. If the client and family have multiple goals including retirement, college education, and lump-sum goals (e.g., new house or second home) the savings rate must be increased.

Question 17

Savings Rate

Answer 17

A rate calculated by taking gross savings in dollars (including employee elective defferals in 401(k), 403(b), and 457 plans plus any employer match), and any other savings dividends by gross pay.

Question 18

Strategic Approach

Answer 18

This approach uses a mission, goal, and objective approach considering the internal and external environment and may be used with other approaches.

Question 19

Two-step/ Three-panel Approach

Answer 19

A step-by-step approach where the client’s actual financial situation is compared against benchmark criteria. It stresses the management of risk, seeks to avoid financial dependence, and promotes savings and investing to achieve financial independence

Question 20

List and define the eight approaches to financial planning analysis and recommendations.

Answer 20

• The life cycle approach is used early in the financial planning engagement and is a brief overview of the client’s financial profile allowing the financial planner to have a focused conversation based on the profile.
• The pie chart approach is a pictorial representation of the client’s financial profile based on the client’s balance sheet and statement of income and expenses.
• The financial statement and ratio analysis approach uses ratios derived from the client’s financial statements that are then compared to benchmark metrics for an evaluation of strengths, weaknesses, and deficiencies.
• The two-step/three-panel approach stresses the management of risk and promotes financial independence through savings and investing.

• The present value of goals approach determines the present value of each of the short-term, intermediate-
term, and long-term goals and compares the sum to the currently available resources. This comparison will
generally yield a deficit that can be amortized over the work life expectancy and compared to the current
savings amount. If the deficit amount is in excess of the current savings then the savings needs to be
increased.

• The metrics approach uses benchmarks for measurement of where a client’s financial profile should be as compared to the client actual.
• The cash flow approach analyzes the income statement to evaluate and prioritize the “purchase” of financial planning recommendations driving down the discretionary cash flow.

• The strategic approach is a mission, goal, and objective driven financial plan that considers a client’s needs
versus wants and is usually used in conjunction with other financial planning approaches.

Question 21

List the three phases of the life cycle approach.

Answer 21

• The asset accumulation phase usually occurs in the early 20s to late 50s when cash flow for investing is low
and debt to net worth is high.

• The conservation/risk management phase occurs from late 20s to early 70s where cash flow and net worth
have increased and debt has decreased somewhat. Risk management of life events like employment, disability, and untimely death become a priority.

• The distribution/gifting phase is from late 40s to end of life and usually is characterized by high additional
cash flow, low debt, and high net worth.

Question 22

What are some of the questions that an income statement pie chart will answer?

Answer 22

• How much is the client paying in taxes as a percentage of gross pay?
• What percentage of gross pay is going toward savings?
• What portion of gross pay is spent on insurance (risk management)?
• How much is spent on basic housing costs (and other debt)?
• What portion of the client’s gross pay is left for discretionary spending?

Question 23

What are some of the questions that a balance sheet pie chart will answer?

Answer 23

What percentage of total assets is:

• cash and cash equivalents,
• investment assets,
• personal use assets,
• current liabilities,
• long-term liabilities, and
• net worth?

Question 24

What is an advantage to using the pie chart approach with clients?

Answer 24

The pie charts are effective for assisting client’s to visualize their financial situation including where their assets are deployed in cash, for long term goals, or for maintaining their current lifestyle.

Question 25

What are the liquidity ratios used in the financial statement and ratio analysis approach?

Answer 25

Liquidity ratios measure the ability to meet short-term objectives and include the emergency fund ratio and
the current ratio.

Question 26

Discuss the difference between discretionary and non-discretionary cash flows.

Answer 26

Discretionary cash flows are expenses which can be avoided in the event of a loss of income. Some discretionary cash flows may include the costs of entertainment, vacations, or cable services. Non-discretionary cash flows are mostly fixed expenses which must be met on a regular basis regardless of loss of income. Some non-discretionary cash flows include debt payments (mortgage loan, auto loan, credit cards), insurance payments (life, health, property), and food and clothing.

Question 27

List the four debt ratios used in the financial statement and ratio analysis approach.

Answer 27

Housing Ratio 1

Housing Ratio 2

Debt to Total Assets

Net Worth to Total Assets

Question 28

Discuss the average savings rate for retirement funding and the average retirement withdrawal rate.

Answer 28

The average savings rate to reach the retirement goal is 10-13 percent for a 25-year to 35-year old client. A safe
retirement withdrawal rate is considered to be four percent of the initial capital balance at retirement age. This average can still lead to a retirement surplus or shortfall as client’s needs vary and may change (as health needs increase, for example) over the course of the retirement period. In addition, investment returns are not constant or linear in financial markets. When returns are down, the account balance can be significantly impacted
potentially requiring an adjusted retirement withdrawal rate.

Question 29

List the common performance ratios used in the financial statement and ratio analysis approach.

Answer 29

Return on Investments

Return on Assets

Return on Net Worth

Question 30

Define the two-step approach to financial planning.

Answer 30

The two-step approach focuses on covering the client’s risk and improving saving and investing. Savings and
investments are managed as a means to financial security and the avoidance of dependence on another.

Question 31

What do the three panels of the three panel approach cover?

Answer 31

The three panels guide the client and financial planner toward the goals of covering the risks, savings and
investing. Panel 1 evaluates the risks and the client portfolio of insurance to determine the adequacy of coverage. Panel 2 evaluates short term savings and investments and debt management. The emergency fund ratio and housing ratios 1 and 2 are all calculated to discover the ability to meet short term obligations and to manage debt. Panel 3 focuses on long term savings and investments and determines the level of savings required for long term savings, including lump sum goals.

Question 32

Why is the present value approach easy to understand at the completion of the analysis?

Answer 32

It is easy to understand because a required savings amount is calculated that can be compared to the current
savings amount and a determination can be made to increase or decrease savings as necessary to attain the
financial planning goals.

Question 33

Discuss the usefulness of the metrics approach.

Answer 33

The metrics approach utilizes example benchmarks to guide the financial planner and client towards financial
planning recommendations. Once the financial profile of the client has been determined example metrics/
benchmarks can be used as a guide to reach the client’s priorities, goals, and objectives. Comparison of the client actual to benchmarks for risk management, short-term savings and investing, and long-term savings and
goals can benefit by providing measurable goals that result in the desired financial outcome.

Question 34

What is the usefulness of the cash flow approach to financial planning?

Answer 34

The cash flow approach takes an income statement approach to planning by adjusting discretionary cash flows and accounting for the “purchase” of recommendations in order of priority. The approach enables the financial planner and client with a way to “buy” recommendations as the client can afford to implement the financial plan. This approach focuses on priorities under the categories of risk management, debt management, and savings and investment management.

Question 35

Define the strategic approach to financial planning.

Answer 35

The strategic approach to financial planning is appealing to a client that has a mission and is ready to create a
mission statement based on goals that then can be carried out by specific narrow objectives. The financial
planner may choose to use the strategic approach at the beginning of the engagement and then continue the
analysis, evaluation, and recommendations based on other approaches (such as the cash flow approach).

Question 36

Discuss whether capital gains, dividends, interest and other portfolio income should be part of the savings ratio.

Answer 36

Capital gains, dividends, interest and other portfolio income should not be part of the savings ratio since these are components of the investment return. If they were included in the savings amount, then they would be
double counted.